The Car Market Bubble Just Popped

What's up you guys, it's Graham here.

So first of all, I got to say I am shocked that more people aren't talking about this because we're facing a huge problem in the used car market, and honestly, it's a disaster waiting to happen. Like, we all know that used car prices have gotten really expensive, but did you know that those car prices have outperformed the stock market in 2020, 2021, and also 2022? In just the last year, used car prices have increased 40%, which is twice the growth of the housing market, four times the growth of contemporary art, and five times higher than the 40-year record-breaking inflation of 82%.

However, the days of used cars selling for more than new are beginning to come to an end, with the automotive industry on the brink of an auto loan collapse that has the potential to shake out the entire market as defaults begin to increase on predatory loans that never should have been issued to begin with. But hey, at least on the bright side, they arrested an avocado thief in California.

Anyway, let's talk about the current state of the auto industry, how this quietly became one of the most egregious bubbles that very few people are talking about, and how this will likely affect the value of vehicles over these next few years, for better or, I guess, for worse. Although before we start, there was a lot of research that went into making a video like this so it's factually correct and accurate as of the time I'm posting this video. So if you appreciate that, it would mean a lot to me if you subscribed or hit the like button for the YouTube algorithm, so that more people could see exactly what's going on.

Alright, so for anyone who's ever wondered how on Earth we got here, why 82% of cars are selling for over MSRP, and how this was even allowed to get so out of control, it's all Jerome Powell's fault. He did it. Okay, not really, but just like everything else, 2020 has been a hell of a drug. See, in most normal circumstances, when you go and buy a new car, that car loses, on average, 11% as soon as you drive it off the lot. Within a year, it's lost 25% of its value, and within 5 years, the average car is worth 63% less than it would cost new.

This makes sense because technology is dated, the car experiences wear and tear, and it's no longer the latest design. But in 2020, auto manufacturing completely stopped in the wake of the shutdown. This meant that for a brief period of time, no new cars were being built. Although what made the situation worse wasn't so much the auto manufacturers but instead the tiny little chips that went inside the car. And no, not those chips. These chips, semiconductors like this, make it possible for the car to control everything from the windows, the sensors, the ignition, navigation, and everything else. So much so that a modern car requires in excess of several thousand chips.

Even though that sounds like a lot, the auto industry only uses about 3% of the global chip supply. The rest gets used by consumer electronics like smartphones, which saw a record increase throughout 2020 and 2021. So those products get priority. As a result, excess demand combined with manufacturing delays, a lack of labor, and a supply chain crisis led to a shortage of semiconductor chips, which of course led to a shortage of new cars being completed.

In fact, the UK suffered its worst manufacturing year since 1956 in terms of output, and the US continues to halt production on their most popular vehicles simply because they don't have the components to finish them. That means higher prices for everybody else. At the same time, demand for cars has skyrocketed to the point where buyers are willing to pay a premium just to get anything that they can. And all of a sudden, a 3-year-old car is selling for more than its original sticker price brand new. And that's where the problem begins.

See, when buyers purchase a car, the vast majority of them are financed. In fact, 85% of new car purchases are bought with debt, along with 55% of used car purchases. And what makes this so unique is that unlike real estate, auto loans are not subject to strict underwriting requirements, allowing nearly anyone to get a loan if they really want to drive off with the new purchase. It's so bad that Jalopnik ran a story in late 2021 detailing just how easy it was to get a loan and how predatory those loans become, calling it a true wild wild west and a poorly regulated wasteland.

Or in other words, borrowers with great credit scores are being funneled into high interest loans that were more than double the average rate. On top of that, 25% to 50% of loans were given to customers who might not be able to afford them. To make matters even worse, lenders rarely verified income and employment to borrowers to confirm that they had sufficient income to repay the loan. Consumer Reports looked at these verifications and found they happen just 4% of the time.

And if that wasn't unbelievable enough, as of now, 5% of auto loans in the US are behind on payments, and nearly half are underwater, where the buyer owes more on the car than what the car is actually worth. And that says a lot when you consider that auto prices are already significantly higher than they were 2 years ago. Just like the housing market collapsed from the loan crisis in 2008, it's said that the same thing is beginning to happen in the automotive industry, and I didn't even believe it until I saw the numbers.

Alright, so when it comes to the current state of the auto industry, here's the thing: when a buyer obtains a loan, whether it be through a bank or a dealership, those loans are bundled together and sold on the secondary market for investors who want to get paid back with interest. In return, lenders get their money back plus a small fee, and they could use those proceeds to hand out new loans to start the process over again.

With the real estate market, this spelled disaster because subprime loans were falsely packaged as safe investments. When homeowners couldn't afford those monthly payments, they defaulted. Banks couldn't pay back their investors, and everything went to poop. Since then, lenders have strengthened their requirements, increased down payments, and verified financials. But with the car market, that's not being done. Instead, investors have had such a big appetite for buying up packaged car loans that they're selling at the fastest pace in years, to the point where subprime auto bonds with junk ratings have been selling at yields as low as 3% versus as high as 9% four years ago.

This essentially means that investors are highly unlikely to see a positive return on their investment because 3.5% is nowhere close to compensating on the level of risk associated with lending money on a vehicle that's probably not worth the price that they paid. Right now, the auto loan industry is a $1.4 trillion market. On top of that, as car prices have risen, lenders have offered longer loan terms to allow for more people to finance a car. Experian noted that the number of car loans of 72 months or longer is the highest it's ever been.

Even more concerning is that some lenders are willing to finance up to 125% of the car's value. So if you bought a car for $33,000, you would be able to get $37,500 to include sales tax, registration, title, and fees. Then instantly you're in the negative without even turning on the car. Now, in all fairness, negative equity like this is nothing new, and unlike a house, repossessing an auctioning off a car to recoup some of your investments is a fairly quick process.

But the magnitude of which this is occurring is beginning to draw some concern. And this is what we have to get to: as supply chain constraints, production, and chip manufacturing begin to improve, used car prices are beginning to drop down 6.4% since the record high in January. This also marks the fourth consecutive month that auto prices have fallen. In the first month, sales declined 17.7%. Even though this is certainly good news for anyone who's soon to be in the market for a car, it's a nightmare for banks who have lent money on those cars at a value that's rapidly beginning to fall.

Right now, it's said that investors are willing to bet that consumers will keep paying their loans in the near term because, after all, a car could be an essential purchase that allows people to go to and from work or be used as a way to make money. But that might not necessarily continue. A survey from Fannie Mae found that 16% of consumers said that they expected to lose their job in the next 12 months, and that is generally the time when finances get tight and people cut back on the items that are costing them too much money, or in this case, it's expensive auto loans.

Just recently, it was reported that 82% of subprime borrowers defaulted on their car loans, which is the second highest total on record. The Wall Street Journal even found that more subprime borrowers have started missing payments as rising prices force households to choose between paying for the essentials or paying off loans. Now the government is warning about a surge in car repos, and that the problems could get much worse unless we stay ahead of it.

The reality is lenders have potentially given buyers unaffordable loans without verifying their financials on values that can't be sustained. Without a chip shortage, it's only a matter of time until eventually, things have to come down and return to normal. The reality is for most people, just like a house, a car could be a necessity. But just like any payment, it needs to be affordable; otherwise, you run the risk of making a huge mistake.

In most cases, the rule of thumb here is what's called the 2410 rule: 20% down payment on a 4-year loan where you spend no more than 10% of your monthly income on transportation. But what actually happens is completely the opposite. Instead, the average payment is just 11.7% on a 72-month loan, with a car that's being kept for 71.4 months. So basically, people aren't even finished making their payments before they roll that into a brand new loan that starts the process all over again.

So between an unprecedented surge in prices, rising interest rates, and chip manufacturing beginning to return to normal, we should expect auto prices to begin to fall right alongside with your cryptocurrency investments. Just kidding. But seriously, KPMG predicts that used car prices could drop 30% as more supply hits the market, and Ally Financial predicts a 20% decline. The timing is a bit uncertain, but it does look like it's starting to unravel over the next 12 to 18 months.

Overall, from everything that I have researched, my biggest concern is that too many people have locked themselves into auto loans that were more expensive than they could afford. In the event of a job loss or a reduction in income, those people wouldn't be able to sell the car for as much money as they owe. And if they can't come out of pocket on a $25,000 car that they owe $35,000 on, they'll have no other choice other than to get their car repossessed, flooding the market with more inventory and causing prices to decline even further.

This is especially true right now when more than half of all auto loans are underwater, meaning they owe an average of $3,700 more than what the car is actually worth, and that negative equity is only going to get worse the more auto values decline. At a certain point, it's just not sustainable, and that needs to be acknowledged. We also have businesses like Carvana, who actively lose $3,200 for every car sold, and when they have more than 55,000 cars, that's a lot of losses that have to go somewhere, like their stock, which is also down 91% year to date.

Now, on the bright side logistically, don't expect this to be anywhere near the size of the housing collapse because loan sizes are significantly smaller, and it's a lot easier to repo and auction a car than it is to foreclose on a home. In addition to that, most auto loans have a fixed interest rate, so even though a buyer may owe way more than the car is worth, as long as they can continue making those monthly payments, the solution is to hold on to the car longer than expected and keep driving it until eventually they break even.

The best strategy in this case is to simply recognize that 40% price increases year-over-year are not sustainable or to be expected. If you find yourself with a loan that might not be affordable, now would be a good time to either lower your interest rate or drive something less expensive so that way you could save the difference. This is certainly something to be made aware of, and if you don't believe me, a link to my newsletter down below in the description where you can see each and every single one of my sources.

Very few people are talking about this, and the more people understand what's going on, the more we could prevent the problem from only getting worse in the future. Just buy a car that you could comfortably afford, pay it off as soon as possible, drive it for as long as you can, and then subscribe if you haven't done that already. I had to put that one in somewhere. So thank you guys so much for watching. Also, feel free to add me on Instagram, and till next time.